When determining the type of mortgage that is best suited for you, one factor to consider is the Prepayment Penalty.
A Prepayment Penalty is a fee that your lender may charge if you make more than the allowed additional payments toward your mortgage, or you pay off your mortgage entirely before the end of your mortgage term.
A prepayment penalty can cost thousands of dollars. It is important to know when it applies and how your lender calculates it.
Open Mortgage vs. Closed Mortgage
An Open Mortgage can have a fixed interest rate or a variable interest rate. A Closed Mortgage can have a fixed interest rate or a variable interest rate. The difference in the two is your ability or inability to prepay your mortgage.
An Open Mortgage allows you to prepay any amount of your mortgage at any time without a prepayment penalty charged to you.
A Closed Mortgage has a prepayment limit, permitting you to make additional payments towards your mortgage on top of your regular mortgage payments, without having to pay a prepayment penalty. Such prepayment privileges may allow you to increase your regular payment by a certain percentage, and/or make a lump-sum payment up to a certain amount or percentage of the original mortgage amount.
These privileges will vary from lender to lender. Note that some lenders will not permit any prepayments whatsoever.
The number of additional payments allowed, the minimum amount of each additional payment, when those additional payments can be made, and whether that year consists of the calendar year or the mortgage year; are the kinds of prepayment terms and conditions that will differ for each mortgage lender.
Most people often choose a closed mortgage, as the interest rate of a Closed Mortgage tends to be lower.
What Is the Amount of the Prepayment Penalty?
If your Closed Mortgage has a variable interest rate, you will normally have to pay three months’ interest.
If your Closed Mortgage has a fixed interest rate, you will normally have to pay the greater of:
- three months’ interest; or
- the Interest Rate Differential.
The Interest Rate Differential is the difference between the interest rate on your current mortgage term and today’s interest rate for a term that is the same length as the remaining time left on your current term. Each lender calculates the Interest Rate Differential differently—there is no one set calculation of the Interest Rate Differential. The Interest Rate Different can be SIGNIFICANTLY higher than the standard three months’ interest penalty.
Generally, the Interest Rate Differential will apply when the borrower prepays earlier in the mortgage term, and/or the interest rates have fallen since the time the Borrower obtained that mortgage.
Every lender is different, so you will want to discuss this with your mortgage broker or mortgage specialist.
Who Cares About the Prepayment Penalty, Unless I Win the Lottery….Right?
You should most definitely care.
People generally pay out their mortgage before the end of their term one of two ways:
- Early Refinance: Perhaps during the third or fourth year of your 5-year mortgage, you want to move to another bank that is offering you a better interest rate. To secure the new mortgage, you have to pay out the existing mortgage. The existing mortgage lender will then add the Prepayment Penalty. You may also have to pay the Prepayment Penalty if you are wanting to borrow more money using the increased equity in your home, even though you are sticking with the same lender.
- Sale of Property: If you are going to sell the Property, then you will have to clear title by paying out the existing mortgage. The existing mortgage lender will then add the Prepayment Penalty.
Note some lenders don’t even allow a mortgage to be broken unless of a bona fide sale…even if you win the lottery and want to pay out the mortgage.
Portable Mortgages
If you are selling your existing home and buying a new home around the same time, you may want to consider porting your mortgage. This option lets you transfer the interest rate and the existing terms and conditions of your current mortgage to your new home. By doing so, you can potentially avoid paying the Prepayment Penalty.
Note that lenders will require that you meet certain conditions in order to port your mortgage. The most common requirement is that the sale and purchase must close within a certain period of time. Although 30-90 days is the norm, some lenders may even require that the sale and purchase close on the exact same day. If considering this option, contact your mortgage broker or mortgage specialist.
If your sale is scheduled to complete before your purchase completes, very often the Prepayment Penalty is paid up front. When the purchase completes, the mortgage lender will make arrangements to refund you the amount of the Prepayment Penalty. Each lender is different. For clarification, contact your mortgage broker or mortgage specialist.
The Prepayment Penalty is One of Many Factors When Deciding on a New Mortgage—NOT the Only One
If you know that you are in the process of paying out your mortgage, go to your bank and ask for an estimate of the prepayment penalty. Although that number can vary day to day, it will at least give you an idea of what to expect when you end up finally paying out the mortgage.
But note that while paying a Prepayment Penalty is rarely pleasant, it should not necessarily dissuade you from getting a new mortgage with another lender. While you may have to pay the prepayment penalty upfront, you may save more money by getting that new mortgage with another bank in the long run because of the significantly lower interest rate. This is where you will have to do some math. With the help of your mortgage broker or mortgage specialist, you will likely come to an answer that best suits you.
If you have any questions about this post, please contact Lewis Nguyen at lewis@dbmlaw.ca or 604-937-6373.